Level I - Quantitative Methods

Time Value of Money

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 Contents
1. Introduction
2. Interest Rates
3. Future Value of a Single Cash Flow
4. Non-Annual Compounding (Future Value)
5. Continuous Compounding, Stated and Effective Rates
6. Future Value of a Series of Cash Flows
7. Present Value of a Single Cash Flows
8. Non-Annual Compounding (Present Value)
9. Present Value of a Series of Cash Flows
10. Present Value of a Perpetuity and Present Values Indexed at Times Other Than t=0
11. Solving for Interest Rates, Growth Rates, and Number of Periods
12. Solving for the Size of Annuity Payments
13. Present Value and Future Value Equivalence, Additivity Principle

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 1. Introduction
• Time value of money

• Interest rates

• Present value

• Future value

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 2. Interest Rates: Interpretation
Interest rates can be interpreted as:
1. Required rate of return
2. Discount rate
3. Opportunity cost

Say you lend $900 today and receive $990 after one year

Required Rate of Return Discount Rate Opportunity Cost

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 Interest Rates: Investor Perspective

As investors, we can view an interest rate as:

Nominal Real risk-free interest rate +

Risk-free
Rate Inflation premium +
Default risk premium +
Liquidity premium +
Maturity premium

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 Practice Question 1
Jill Smith wishes to compute the required rate of return. Which of the
following premiums is she least likely to include?
A. Inflation premium
B. Maturity premium
C. Nominal premium

Answer: C

Required rate of return includes inflation premium, maturity premium, default

risk premium, and liquidity premium. There is no such component as a
nominal premium.

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 Practice Question 2
Which of the following is least likely true?
A. Discount rate is the rate needed to calculate present value
B. Opportunity cost represents the value an investor forgoes
C. Required rate of return is the maximum rate of return an investor
must receive to accept an investment

Answer: C

Required rate of return is the minimum rate of return an investor must

receive to accept an investment. Therefore, option C is least likely to be the
interpretation of interest rates.

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 Practice Question 3
Investments Maturity Liquidity Default risk Interest Rates (%)
(in years)
A 1 High Low 2.0
B 1 Low Low 2.5
C 2 Low Low r
D 3 High Low 3.0
E 3 Low High 4.0

1. Explain the difference between the interest rates on

Investment A and Investment B.

2. Estimate the default risk premium.

3. Calculate upper and lower limits for the interest rate on

Investment C, r.

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3. Future Value of a Single Cash Flow
PV = 100 and r = 10%
FVN = PV (1 + r)N What is the FV after one year?
What is the FV after two years?

0 1 2

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 Practice Question 4
Cyndia Rojers deposits $5 million in her savings account. The account holders are
entitled to a 5% interest. If Cyndia withdraws cash after 2.5 years, how much cash
would she most likely be able to withdraw?

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 FV Calculation Using a Financial Calculator
Keystrokes Explanation Display
Set to floating decimal
[2nd] [FORMAT] [ ENTER ] Get into format mode DEC = 9
[2nd] [QUIT] Return to standard calc mode 0

You invest $100 today at 10% compounded annually. How

much will you have in 5 years?
Keystrokes Explanation Display
[2nd] [QUIT] Return to standard calc mode 0
[2nd] [CLR TVM] Clears TVM Worksheet 0
5 [N] Five years/periods N=5
10 [I/Y] Set interest rate I/Y = 10
100 [PV] Set present value PV = 100
0 [PMT] Set payment PMT = 0
[CPT] [FV] Compute future value FV = -161.05

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 4. Non-Annual Compounding (Future Value)
You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated
annual interest rate of 10% compounded quarterly. How much will you
have at the end of three years?

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 Multiple Compounding Periods - Calculator
You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated annual
interest rate of 10% compounded quarterly. How much will you have at the end of
three years?

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 Practice Question 5
Donald invested $3 million in an American bank that promises to pay 4% compounded daily. Which
of the following is closest to the amount Donald receives at the end of the first year? Assume 365
days in a year.
A. $3.003 million
B. $3.122 million
C. $3.562 million

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 5. Continuous Compounding
Infinite compounding periods per year  continuous compounding

FVN = PV e r N

An investment worth $50,000 earns interest that is compounded

continuously. The stated annual interest is 3.6%. What is the
future value of the investment after 3 years?

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 Concept Building Exercise
Assume the stated annual interest rate is 12%. What is the future value of $100 at
different compounding frequencies?

Frequency Future value of $100 Return

Annual 112 12.00%

Semiannual 112.36 12.36%

Quarterly

Monthly

Daily

Continuous

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 5.1 Stated and Effective Rates
With a discrete number of compounding periods:
EAR = (1 + Periodic interest rate)m – 1

With continuous compounding:

EAR = er – 1

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 6. The Future Value of a Series of Cash Flows
• Annuity: finite set of level sequential cash flows

 Ordinary annuity: an annuity where the first cash flow occurs one period from today

0 1 2

 Annuity due: an annuity where the first cash flow occurs immediately

0 1 2

• Perpetuity: set of level never-ending sequential cash flows with the first cash flow
occurring one period from today

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6.1 Equal Cash Flows – Ordinary Annuity

Ordinary annuity with A = 1,000 r = 5% and N = 5

0 1 2 3 4 5

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 Ordinary Annuity - Formula

Ordinary annuity with A = 1,000 r = 5% and N = 5

0 1 2 3 4 5

FVN = A {[(1+r)N – 1]/r}

FVN = A {Future Value Annuity Factor}

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 Ordinary Annuity - Calculator
Ordinary annuity with A = 1,000 r = 5% and N = 5

N=5

I/Y = 5

PV = 0

PMT = 1,000

CPT FV

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 Practice Question 6
Haley deposits $24,000 in her bank account at the end of every year. The account
earns 12% per annum. If she continues this practice, how much money will she have
at the end of 15 years?

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 Practice Question 7
Iago wishes to compute the future value of an annuity worth $120,000. He is aware
that the FV annuity factor is 21.664 and the interest rate is 4.5%. Which of the
following is least likely to be useful for the future value computation?
A. Annuity worth
B. Future value annuity factor
C. Interest rate

Answer: C

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 6.2 Unequal Cash Flows

Time Cash Flow ($)

1 1,000
2 2,000
3 3,000
4 4,000
5 5,000

What is the future value at year 5?

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7. Finding the Present Value of a Single Cash Flow

PV = FVN (1+r)-N

For a given discount rate, the farther in the future the amount to be received,
the small the amount’s present value.

Holding time constant, the larger the discount rate, the smaller the present
value of a future amount.

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 Practice Question 8
Liam purchases a contract from an insurance company. The contract promises to pay
$600,000 after 8 years with a 5% return. What amount of money should Liam most
likely invest? Solve using the formula and TVM functions on the calculator.

Answer: 406,104

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 Practice Question 9
Mathews wishes to fund his son, Nathan’s, college tuition fee. He purchases a security
that will pay $1,000,000 in 12 years. Nathan’s college begins 3 years from now. Given
that the discount rate is 7.5%, what is the security’s value at the time of Nathan’s
admission?

Answer: 521,583

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 Practice Question 10
Orlando is a manager at an Australian pension fund. 5 years from today he wants a
lump sum amount of AUD40, 000. Given that the current interest rate is 4% a year,
compounded monthly, how much should Orlando invest today?

Answer: 32,760

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 8. Non-Annual Compounding (Present Value)
You want to know how much to deposit today to receive a lump-sum
payment of $100,000 after 5 years. This amount will be invested in a 5-
year certificate of deposit that offers a stated annual interest rate of 10%
compounded quarterly. How much should you invest today?

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 9. Present Value of a Series of Cash Flows
• Present value of a series of equal cash flows (annuity)

• Present value of a series of unequal cash flows

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9.1 Present Value of a Series of Equal Cash Flows
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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PV of an Ordinary Annuity: Using the Formula
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

PV = A {[1 – 1/(1+r)N]/r}

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PV of an Ordinary Annuity: Using the Calculator
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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 Annuity Due – The Concept
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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 PV of an Annuity Due: Using the Formula
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5

PV (annuity due) = A {[1 – 1/(1+r)N]/r} (1+r)

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 PV of an Annuity Due: Using the Calculator
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5
Key Strokes Display
[2nd] [BGN] [2nd] [SET] BGN
[2nd] [QUIT] BGN 0
[2nd] [CLR TVM] BGN 0
5 [N] BGN N=5
5 [I/Y] BGN I/Y = 5
10 [PMT] BGN PMT = 10
0 [FV] BGN FV = 0
[CPT] [PV] BGN

[2nd] [BGN] [2nd] [SET] END

[2nd] [QUIT] 0

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9.2 The Present Value of a Series of Unequal Cash Flows

Find the present value of each individual cash

Sum the respective present values

0 1 2 3

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 Practice Question 12
Andy makes an investment with the expected cash flow shown in the table below.
Assuming a discount rate of 9% what is the present value of this investment?
Time Period Cash Flow($)
1 50
2 100
3 150
4 200
5 250

Answer: 550

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 10. Present Value of a Perpetuity

PV = A/r

Present value is one period before the first

cash flow

Simple example to understand the formula:

You invest $100 and get 5% for ever. What is
the cash flow?

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10.1 Present Values Indexed at Times Other Than t=0

An annuity or perpetuity beginning sometime in the future can be expressed in present

value terms one period prior to the first payment

Discount back to today’s present value

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 Practice Question 11
Bill Graham is willing to pay for a perpetual preferred stock that pays dividends worth
$100 per year indefinitely. The first payment will be received at t = 4. Given that the
required rate of return is 10%, how much should Mr. Graham pay today?

Answer: 751.31

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 11.1 Solving for Interest Rates and Growth Rates
A $100 deposit today grows to $121 in 2 years.
What is the interest rate? Use both the formula and the
calculator method.

The population of a small town is 100,000 on 1 Jan

2000. On 31 December 2001 the population is
121,000. What is the growth rate?

You invest $900 today and receive a $100 coupon

payment at the end of every year for 5 years. In
addition, you receive $1,000 and the end of year 5.
What is the interest rate?

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 11.2 Solving for the Number of Periods
You invest $2,500. How many years will it take to triple the amount given that
the interest rate is 6% per annum compounded annually? Use both the formula
and the calculator method.

Answer: 18.85 years

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 12. Solving for the Size of Annuity Payments
Freddie bought a car worth $42,000 today. He was required to make a 15% down payment. The
remainder was to be paid as a monthly payment over the next 12 months with the first payment
due at t=1. Given that the interest rate is 8% per annum compounded monthly, what is the
approximate monthly payment?

Answer: 3,106

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 13. Review of Present and Future Value Equivalence

Ordinary annuity with A = 10 r = 5% and N = 5  PV = 43.29

A lump sum can be considered equivalent 0 1 2 3 4 5

to an annuity

Lump sum = PV = 43.29

An annuity can be considered equivalent

to a future value

FV = 55.26

A lump sum can be considered equivalent

to a future value

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 13.1 The Cash Flow Additivity Principle

Amounts of money indexed at the same point in time are additive

0 1 2 3

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 Summary
1. Interest Rates

2. Future Value

3. Present Value

4. Solving for Rates, Number of

Periods, or Size of Annuity
Payments
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 Conclusion

• Learning Outcomes
• IFT Notes
• IFT Qbank
• Curriculum Practice Problems
• Curriculum Examples

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